Stocks Pickers Vs Index Funds: The Debate Rages On

Chris Taylor,|Special to CNBC.com

Wednesday, 28 Oct 2009 | 11:19 AM ETCNBC.com

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In the investing world, the rivalry is akin to the Capulets and the Montagues. In one corner, active stockpickers and their belief in talented fund managers who can outperform the market; in the other, passive investors who prefer less-risky portfolios of low-cost broad market indices.

It’s a question that will be debated forever on trading-room floors and investor chat rooms, but what investors want to know: Who has the best approach for right now, after a quick post-collapse runup that has the Dow Jones Industrial Average breaking the magical 10,000 level?

The answer might be different than you expect. Conventional wisdom holds that active management performs best in a declining market, when stockpickers can sidestep the dogs like a Lehman Brothers or an AIG . But here’s a secret: It’s a total myth.

“Everyone believes that active investors do well in bad markets,” says Srikant Dash, global head of research and design for S&P Index Services. “But when we looked at the bad markets of 2002 and 2008, we showed conclusively that it’s not true.”

What Dash found in his SPIVA scorecard that compares active and passive investing: Then—and over any five-year time horizon you’d care to mention—about two-thirds of fund managers underperform the stock market. In other words, over the long term, plain-vanilla index funds clobber many of the best minds in the business.

For right now, though, there’s some evidence that active investors could be coming into their moment. After all, the Dow was up an eye-popping 15 percent last quarter, as investors regained their confidence and money rushed back in from the sidelines. That’s the Dow’s best performance since 1998, rebounding smartly from a low of around 6,500.

If one assumes that such a rapid ascent won’t be replicated in the near-term, and that we can expect a relatively flat, range-bound market in coming months, then broad indices won’t be going anywhere. Active managers, on the other hand, could thrive with their more judicious stockpicking.

Just ask George Athanassakos. The chair of the Ben Graham Centre for Value Investing in London, Ontario, Athanassakos ran a study comparing a stockpicking approach to the performance of market indexes. He discovered that in straight bull markets, when a rising tide lifted all boats, his value-oriented stock selections were almost exactly aligned with the broader market.

But in flat or zig-zag markets, his active style destroyed the indices, beating them by almost 50 percent. If that’s the kind of market we’re entering, then active investors should take heart.

“When the market goes up, then everyone is doing well,” says Athanassakos, a finance professor and author of the book "Equity Valuation." “It’s hard to buy low and sell high when there’s a straight line up. So active management becomes especially important when the market moves within a band.”

Moreover, it’s usually in the aftermath of a big market move, like the one we’ve just experienced, that you discover a few glaring market inefficiencies.

“When prices have all moved in one direction, there’s more opportunity for mispricing to emerge,” says Josh Peters, an equities analyst with Chicago-based research firm Morningstar.

And a continued bull run looks unlikely, Peters suggests, since underlying fundamentals like corporate revenues and abysmal employment figures mean the economy’s not out of the woods yet.

If that’s the case—that the general market takes a breather, and some relative values begin to stick out—then where should stockpickers place their bets? Active investors would do well to focus on yields, Peters advises.

After all, if stock prices remain range-bound, then it’s dividend payouts that will largely be determining your returns. High-yielding, blue-chip firms tend to be resilient, without a huge downside, because investors are attracted to the stability and income they provide.

They’ve also been lagging the broader market recently, as the hottest stars have been previously left-for-dead firms like MGM. That discrepancy makes for some juicy values. Some of Peters’ picks: Johnson & Johnson , Abbott Labs, and Altria , all overlooked giants that continue to throw off cash.

“They’re not trading at unreasonable valuations, those stocks don’t need a quick V-shaped recovery,' he says. "And you don’t need a whole lot to go right for those investments to work.”